Working Paper: NBER ID: w1902
Authors: Jacob A. Frenkel; Assaf Razin
Abstract: This paper examines the viability of dual exchange-rate regimes. Typically, under such a regime the exchange rates applicable to current-account(commercial) transactions and to capital-account (financial) transactions differ from each other. This difference may be determined in the free market if the authorities peg the commercial exchange rate and set a binding quota on external borrowing, or it may result from direct pegging of both exchange rates. The analysis starts with a specification of the characteristics of the distortion introduced by the exchange-rate premium (that is, the percentage discrepancy between the financial and the commercial exchange rates), and then provides explicit formula for the equilibrium premium, for its evolution over time and for the welfare cost induced by the distortion. The paper outlines the set of policy options consistent with sustaining a permanently viable dual exchange-rate system and highlights the severe constraints that intertemporal solvency requirements of the private sector and of the government impose on the long-run viability of the regime. The paper concludes with an analysis of the monetary changes associated with dual exchange-rate policies and draws the implications of such a regime for the intertemporal distribution of taxes and for the intergenerational distribution of welfare.
Keywords: Dual Exchange Rate; Economic Distortion; Capital Flows; Inflation; Intertemporal Solvency
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adoption of a dual exchange rate regime (F31) | distortion into the economic system (P19) |
| dual exchange rate premium (F31) | intertemporal distribution of taxes and welfare (H23) |
| binding quota on external debt (F34) | equilibrium financial exchange rate exceeds pegged commercial rate (F31) |
| intertemporal solvency constraints (D15) | long-run viability of the dual exchange rate regime (F31) |
| monetary changes associated with dual exchange rate policies (F31) | capital flows (F32) |
| monetary changes associated with dual exchange rate policies (F31) | inflation (E31) |